Ready for a Rally?

In spite of the many bearish posts my baseline asset allocation model retains a generous portion of equities.  While the current economic outlook is the most concerning in my lifetime, we really don’t know what the future holds.  As the current issue of The Economist states in, Ready for a Rally?,

An equity rally could occur even if the global economy is in for a prolonged period of weakness. Two of the best years for Wall Street in the 20th century were 1933 and 1935, despite the severity of the Depression. The value of the London stockmarket more than doubled in 1975, in the midst of a stagflationary crisis and the year before Britain had to ask the IMF for an emergency loan.

It is well known that markets anticipate recoveries.

David Bowers of Absolute Strategy Research argues that investors are positioned as if 2009 will see a rerun of the 1930s Depression, having sold equities and commodities and pushed government bond yields down to very low levels. But what if all the measures taken by governments and central banks actually work? Interest rates have been slashed, taxes have been cut, money has been bumped into the banking system. The effect of these policies might come through in 2009, since both monetary and fiscal policy always take a while to have an effect.

If the markets begin to see signs of recovery then they should start rebounding well in advance of recovery in the “real economy”.  The big question is, are the global stimulus packages going to work?  Are the warnings from Krugman and the IMF that larger stimulus is needed accurate or overly pessimistic concerns?  Only time will tell.  But, as San Francisco Fed President Janet Yellen recently said (via Calculated Risk):

I agree … that the current downturn is likely to be far longer and deeper than the “garden-variety” recession in which GDP bounces back quickly. … Typically, recessions occur when monetary policy is tightened to subdue the inflationary pressures that emerge during a boom. This time, the cause was the eruption of a severe financial crisis. Cross-country evidence suggests that, following such an event, GDP remains subdued for an extended period. And consistent with this evidence, many forecasters expect this to be one of the longest and deepest recessions since the Great Depression. Indeed, the crisis is ongoing. Risk-aversion in financial markets remains exceptionally high; deleveraging is widespread; the markets for most private asset-backed securities are dysfunctional; financial institutions, both large and small, have failed; and the economic downturn is causing delinquencies to rise, threatening further financial distress; households and businesses face an ongoing credit crunch; and housing and financial wealth has plunged. … the likely impact on consumer spending of the decline in wealth thus far—one of a number of factors weighing on this sector—is, on its own, quite substantial. And house prices are continuing to slide.

If ever, in my professional career, there was a time for active, discretionary fiscal stimulus, it is now. Although our economy is resilient and has bounced back quickly from downturns in the past, the financial and economic firestorm we face today poses a serious risk of an extended period of stagnation—a very grim outcome. Such stagnation would intensify financial market strains, exacerbating the problems that triggered the downturn. It’s worth pulling out all the stops to ensure those outcomes don’t occur.

This is from one of the Fed Presidents!


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